Chapter 7: Merchandise Inventory

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2 Chapter 7: Merchandise Inventory 2

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4 Merchandise Inventory What is inventory? Items held for resale to customers Who has inventory? Wholesaler or Retailer - Merchandise Inventory Manufacturer - Raw Materials - Work in Process - Finished Goods 4

5 Merchandise Inventory 1. Acquisition of inventory: What costs to capitalize? 2. Recording inventory activity: Which method? 3. Selling inventory: Which cost flow assumption? 4. Ending inventory: Lower-of-cost-or market valuation. 5

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7 1. Acquiring Inventory What items or units to include? General rule: complete and unrestricted ownership. 7

8 Acquiring inventory - contd. Which costs are included in inventory? General rule: all costs associated with purchase or manufacture, including shipping to facility. Freight-in (transportation-in) adds to the cost of inventory. Purchase returns reduce the cost of purchases (contra) for returned inventory. Purchase allowances reduce the cost of purchases (contra) for reduced prices due to damage or errors. Purchase discounts from early cash payments (contra) reduce the cost of purchases. 8

9 2. Perpetual Method Figure 7.3: Perpetual System December 10 Purchase of 100 $20: Inventory 2,000 Accts. Pay. 2,000 December 20 Sale of 50 $30: Cash 1,500 Sales 1,500 COGS 1,000 Inventory 1,000 December 30 AJE to recognize loss of 5 each (170 on hand, books show 175) Loss 100 Inventory 100 9

10 Class Exercise E Sales $1,262 $1,277 Cost of Goods Sold (COGS): BI $268 $287 Purchases GAS $1,125 $1,174 Less: EI COGS Gross Profit $376 $371 10

11 E7-6 a. Assume that counting errors caused the ending inventory (EI) in 2007 to be understated by $50 and the ending inventory in 2008 to be overstated by $50. Compute the impact of these errors on cost of goods sold for the year ended December 31, 2007 and on the inventory balance as of December 31,

12 E7-6 b. Compute the impact of these errors on cost of goods sold for the year ended December 31, 2008 and on the inventory balance as of December 31, c. What is the impact of these errors on cost of goods sold over the two-year period ended December 31, 2008? 12

13 E7-6 a. Error in Ending Inventory in 2007: The $50 understated error in the Ending inventory means that the Ending Inventory should have been $268 + $50 = $318. This would change the Cost of goods sold to $1,174 - $318 = $856 which would then increase the Gross profit to $421 ($1,277 - $856). 13

14 E7-6 b. Error in Ending Inventory in 2008: = The 2007 error in the Ending Inventory changes the Beginning Inventory in 2008 and the Goods Available for sale to $318 + $857 = $1,175. To calculate the Cost of Goods Sold the Ending Inventory for 2008 is deducted from the revised Goods Available for Sale: $1,175 ($239 - $50) = $986. The gross profit would then be $1,262 - $986 = $

15 E7-6 c Original CGS $906 $886 Corrected CGS $856 $986 15

16 3. Cost Flow Assumptions Given: BI + P (net) = EI + COGS How to assign costs of inflows [BI + P(net)] to EI and COGS? Methods: Specific identification Average for both COGS and EI FIFO - (first-in, first-out) for COGS and LISH (last-in, still here) for EI LIFO - (last-in, first-out) for COGS and FISH (first-in, still here) for EI 16

17 International Perspective Cost Flow Assumptions Under IFRS the LIFO method is prohibited. This poses an important potential impediment to the adoption of IFRS in the US. Most LIFO users in the US have chosen LIFO because it results in an income tax savings. DuPont, for example, has saved over $150 million in income taxes because it uses LIFO. A shift to IFRS could impose a huge and immediate tax burden on LIFO users in the US. 17

18 Cost Flows 18

19 Cost Flows - Average 19

20 Cost Flows - FIFO 20

21 Cost Flows - LIFO 21

22 Cost Flows Effects on Financial Statements 22

23 Cost Flows Effects on Federal Income Taxes 23

24 Choosing an Inventory Cost Flow Assumption: Trade-Offs Income and Asset Measurement Economic Consequences Income Taxes and Liquidity Bookkeeping Costs LIFO Liquidation and Inventory Purchasing Practices Debt and Compensation Practices The Capital Market 24

25 Ending Inventory: Applying the Lower-of-Cost-or- Market Rule Applying the lower-of-cost-or-market rule to ending inventory is accomplished by comparing the cost allocated to ending inventory with the market value of the inventory. If the market value exceeds the cost, no adjustment is made and the inventory remains at cost. If the market value is less than the cost, the inventories are written down to market value with an adjusting journal entry. 25

26 The Lower-of-Cost-or-Market Rule and Hidden Reserves Based on conservatism, ending inventory is valued at cost or market value, whichever is lower. Problem: can create hidden reserves Recognizes price decreases immediately Defers price increase recognition until sold US GAAP and IFRS use different market values when applying the lower-of-cost-ormarket rule. Under US GAAP the market value is usually the replacement cost. Under IFRS it is normally the realizable value. 26

27 International Perspective: Japanese Business and Inventory Accounting Just-in-time (JIT) inventory systems, which reduce the costs of carrying large amounts of inventory without jeopardizing customer service, have long been a characteristic of this Japanese system and have given the Japanese a definite advantage when competing against U.S. industry. Japan has adopted international reporting standards (IFRS), which does not allow the use of LIFO. 27

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